August 24, 2009

Economist's View - 3 new articles

[More Side of the road blogging - stopped for a moment at the Great Salt Lake.] When I talked to the senate's COP panel, one of many things that I emphasized was the need to develop plans in advance to deal with various contingencies. Without such plans policy actions - even justifiable ones - appear ad hoc and also face resistance that delays their implementation or prevents them from being put into place altogether.

For example, we need a plan on the shelf and ready to go for dismantling large banks that have failed, something that has received a lot of attention. It has received much less attention, but I also think we need a plan for disposing troubled financial assets when the need arises. I still believe that the crisis would have been much less severe if very early, prior to Lehman for sure, the government had moved aggressively to buy bad assets from bank balance sheets. it took far too long, and when they finally decided to do this (i.e. the original Paulson plan), they had no idea how to value the assets, there was considerable political resistance because nobody knew how the program would work (allowing lots of false information to enter the debate), and so on, and this program never really got off the ground. The assets are still there waiting for the miracle of rising asset prices to restore their value.

Having a plan ready in advance that specifies how assets will be valued, how taxpayers will be protected if the government overpays (overpaying can help with recapitalization, but it shouldn't be a gift), and so on, a plan that has been approved in advance by legislators (at least implicitly) so as to reduce political resistance, will overcome many of the technical problems and objections that prevented the bad asset removal programs from being used effectively in this crisis.

Keiichiro Kobayashi believes these toxic assets, many of which are still hidden on bank balance sheets, are still a problem and could result in a Japan style lost decade if the government does not remove them, and he calls for a new macroeconomic paradigm that puts these issues front and center (On his main point about whether financial sector recovery is necessary before the real economy can recover, I think we will recover either way, but agree that recovery would be faster if these assets were removed once and for all - but I should get back on the road...):

Why this new crisis needs a new paradigm of economic thought, by Keiichiro Kobayashi, Commentary, Vox EU: The policies being debated in the US and Europe today are almost identical to those that played out in Japan a decade or so ago. Japan experienced the collapse of its colossal property bubble in 1990 and then a series of crises as major banks and securities companies were overwhelmed by rapidly rising non-performing debts. The conventional wisdom among economists and politicians throughout the 1990s was that massive public expenditure and extraordinary monetary easing would give the necessary boost to market sentiments and prompt an economic recovery. Public opinion in the US and Europe today seems to be the same.

And indeed, throughout the 1990s, Japan did introduce major public works projects and tax cuts, yet the economy failed to stabilise, asset prices continued to fall, and the volume of non-performing debts continued to climb. Far from being dispelled, the sense of insecurity that had permeated the markets actually increased throughout the 1990s, ultimately leading to the collapse of several major financial institutions in 1997 and sparking an outbreak of panic.

Even after this, recovery efforts continued to be channelled through large-scale public expenditure, while the disposal of non-performing debts became bogged down. Only around 2001 did Japanese public opinion finally turn away from the belief that reductions in bad debt and financial system stability would follow an economy recovery. The public came to understand that the financial system had to be stabilised and market insecurity dispelled before any recovery could occur. Special inspections were conducted repeatedly by financial regulators and Japanese megabanks were forced to accept massive capital increases and a new round of mergers. Meanwhile, the Resolution and Collection Corporation and the Industrial Revitalisation Corporation of Japan restructured companies that had collapsed under enormous debt burdens and finally broke the back of the non-performing debt problem. This sparked a recovery of market confidence, and Japan enjoyed a period of economic expansion from 2002 to 2007.

Japan redux?

Mainstream opinion in the US and other countries today appears to be similar to the thinking that dominated Japan during the 1990s. The general public, for the most part, have not bought into the theory that stabilising the financial system through means such as temporarily nationalising banks and rehabilitating debt-ridden borrowers is a necessary prerequisite for achieving an economic recovery. In a VoxEU column published on 1 April, I emphasised that there is a danger in expecting too much from fiscal policy. Rehabilitating the US financial system through the disposal of non-performing assets is essential for a global economic recovery. Princeton University Professor Paul Krugman commented on my column at his New York Times blog, claiming that the belief that stabilising the financial system is a necessary precondition for economic recovery is questionable. He said that if bank reform were the major factor in Japan's economic recovery, capital investment should have increased, yet the Japanese data shows no increase in capital investment during the recovery period. My response is that stabilising the financial system alleviated the funding constraints that were making it difficult for companies to meet their working capital needs. As several recent studies show (see, for example, Chari, Kehoe and McGrattan 2007), loosening financial constraints on working capital causes productivity to rise and enables an increase in output and employment, but it does not necessarily result in higher capital investment. There is no contradiction between the Japanese data showing non-increasing capital investment and the hypothesis that stabilising the financial system was a factor behind Japan's economic recovery.

The challenge for macroeconomics

The essence of the debate is whether economic recovery and stabilisation of the financial system are two distinct and unconnected events. The prevailing view is something like – the framework within which we need to engineer a global economic recovery is macroeconomics. Since current macroeconomic theory deals only with Keynesian policy (fiscal and monetary policy), the only tools we have are fiscal and monetary expansion. The disposal of non-performing assets and injection of capital are necessary steps in stabilising the financial system, but to the best of our knowledge there is no clear link between this and a macroeconomic recovery. However, if we achieve an economic recovery through fiscal and monetary policy, the volume of non-performing assets will ease, eliminating the need for policies specifically designed to dispose of bad assets.

The experience of Japan in the 1990s would seem to indicate that these expectations are misplaced. Further evidence is provided by Sweden, which experienced its own asset bubble collapse around the same time that Japan did, but recovered much more quickly after Swedish policymakers designed a surgical bad-asset restructuring.

Signs of economic recovery are now emerging and fears of the crisis overwhelming the world economy are starting to fade. Yet if the policy responses of US and European governments toward the disposal of non-performing assets begin to falter, the financial systems of Europe and the US will once again be vulnerable to recurring financial crises, which Japan experienced repeatedly in the 1990s.

There have been those who have recognised that cleaning up banks' balance sheets and rehabilitating debtors are necessary preconditions for an economic recovery, but this recognition has been based purely on empirical principles. The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context. For example, in the standard New Keynesian or Neoclassical macroeconomic models, the economic agents are the household, corporate, and government sectors, and the financial sector is simply treated as an innocuous veil between these three sectors. The issue of non-performing assets is invariably viewed as a microeconomic issue related to the banking industry.

In fact, the crisis we are currently experiencing may call for a change in the theoretical structure of macroeconomics. In my view, a macroeconomic approach that encompasses financial intermediaries and places them at the centre of its models is necessary. The new approach should satisfy three requirements:

The focus should be on the function of financial institutions as media of exchange and the conditions that might cause payment intermediation to malfunction. Perhaps this kind of macro model can be built on the framework of the monetary theory of Lagos and Wright (2005), which explicitly considers the role of money as a medium of exchange.

The new macroeconomic approach should provide a unified framework for discussing the cost and effectiveness of various policy responses to the current global crisis in an integrated context, in which fiscal policy, monetary policy, and bad asset disposal can be compared and relative weightings can be given to all three.

To provide a unified framework for policy analysis, the new approach should make it easy to embed a model of financial crises into the standard business cycle models (i.e., the dynamic stochastic general equilibrium models).

I have elsewhere attempted to construct a theoretical model that satisfies these requirements, in which I assume that assets such as real estate now function as media of exchange given the development of liquid asset markets but are unable to fulfil this function during a financial crisis (see Kobayashi 2009a). With a model like this, we can regard a financial crisis as the disappearance of media of exchange, which triggers a sharp fall in aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and bad asset disposals can be understood as responses targeting the same goal – restoring the amounts of media of exchange (inside and outside monies). Thus we can compare and analyse these policies in an integrated context.

Bad asset disposal should not be left to financial community insiders

If macroeconomic policy and financial stabilisation through bad asset disposals are designed to eradicate the same externality, financial stabilisation is not just a problem for the financial community – it is crucial for the recovery of the overall economy. Therefore, the design and execution of policies capable of disposing of non-performing assets are not tasks that should be left to financial community insiders. We need to openly discuss what financial stabilisation policies should look like (for practical lessons on the policy package from Japan's experience, see Kobayashi 2008, 2009b). Bad asset disposals including capital injections for financial institutions (or temporary nationalisation) and the rehabilitation of debt-ridden borrowers must be considered alongside fiscal stimuli and monetary easing, with a new awareness that they also constitute macroeconomic policies. Perhaps, we need to adopt a new paradigm of economic thought.

All the President's Zombies, by Paul Krugman, Commentary, NY Times: The debate over the "public option" in health care has been dismaying in many ways. Perhaps the most depressing aspect for progressives, however, has been the extent to which opponents of greater choice in health care have gained traction — in Congress, if not with the broader public — simply by repeating, over and over again, that the public option would be, horrors, a government program.

Washington, it seems, is still ruled by Reaganism — by an ideology that says government intervention is always bad, and leaving the private sector to its own devices is always good.

Call me naïve, but I actually hoped that the failure of Reaganism in practice would kill it. It turns out, however, to be a zombie doctrine: even though it should be dead, it keeps on coming.

Let's talk for a moment about why the age of Reagan should be over.

First of all, even before the current crisis Reaganomics had failed to deliver what it promised. Remember how lower taxes on high incomes and deregulation that unleashed the "magic of the marketplace" were supposed to lead to dramatically better outcomes for everyone? Well, it didn't happen. ...

President George W. Bush, who had the distinction of ... presiding over the first administration since Herbert Hoover in which the typical family failed to see any significant income gains.

And then there's the small matter of the worst recession since the 1930s. There's a lot to be said about the financial disaster..., but the short version is simple: politicians in the thrall of Reaganite ideology dismantled the New Deal regulations that had prevented banking crises for half a century, believing that financial markets could take care of themselves. The effect was to make the financial system vulnerable to a 1930s-style crisis — and the crisis came.

"We have always known that heedless self-interest was bad morals," said Franklin Delano Roosevelt in 1937. "We know now that it is bad economics." And last year we learned that lesson all over again.

Or did we? The astonishing thing about the current political scene is the extent to which nothing has changed.

The debate over the public option has, as I said, been depressing in its inanity. ... But it's much the same on other fronts. Efforts to strengthen bank regulation appear to be losing steam, as opponents of reform declare that more regulation would lead to less financial innovation — this just months after the wonders of innovation brought our financial system to the edge of collapse...

So why won't these zombie ideas die?

Part of the answer is that there's a lot of money behind them. ... In particular, vast amounts of insurance industry money have been flowing to obstructionist Democrats like Mr. Nelson and Senator Max Baucus, whose Gang of Six negotiations have been a crucial roadblock to legislation.

But some of the blame also must rest with President Obama, who famously praised Reagan during the Democratic primary, and hasn't used the bully pulpit to confront government-is-bad fundamentalism. That's ironic, in a way, since a large part of what made Reagan so effective, for better or for worse, was the fact that he sought to change America's thinking as well as its tax code.

How will this all work out? I don't know. But it's hard to avoid the sense that a crucial opportunity is being missed, that we're at what should be a turning point but are failing to make the turn.

Many people - people who make up key voting blocks - are happy with the health care coverage they have now (employer based or Medicare for the most part) and they do not want it to change. Thus, if they can be convinced that they will have to give up some of their own health care (and/or pay much higher taxes) in order to expand coverage to the uninsured, then they will be unlikely to support reform. The government death panel lie plays into people's fear of losing what they have now by implying that choices will be much more limited if reform is enacted, and worse, that someone else will make the choices for you. It promotes the general fear that government involvement means less options than are available now, and that many of the choices will be mandated.

Democrats made a mistake, I think, by not emphasizing that just the opposite is true. It is the failure to reform health care that will limit future choices, perhaps severely if cost projections are realized. Government is the best hope of maintaining the choices that are available now, and of expanding the choices available to those who currently have no health insurance. In light of this, the message from reform supporters has emphasized the need for both cost control and expanded coverage.

The problem with the message is that cutting costs and expanding coverage sounds like it's a tradeoff. That is, it sounds like the intent is to cut costs - partly by limiting choices for those who now have coverage - in order to expand coverage to those who are currently uninsured. Because of this, people who have adequate coverage are afraid of losing options and control over their care. Democrats need to explain that universal coverage and cost control are not tradeoffs in this sense, but rather both of these are elements of an overall strategy to do the best we can to maintain the choices that people now have. It's not one of the other, both are part of a system-wide approach to reform. The same is true with other elements of the plan such as the public option. This doesn't take away the choice of health care plans, it adds one and if people don't like it, they don't have to use it.

The point that Democrats must make clear is that doing nothing puts people's existing health care coverage at substantial risk. People should be very afraid if reform fails, especially people who have good coverage now since they're the ones with the most to lose. So while I wholeheartedly agree that Democrats need to confront "government-is-bad fundamentalism," they also need to make clear how government can do good. System-wide reform of health care is the best chance people have for a health care system that meets their needs at least as well as what they have now, and the necessary reform cannot be accomplished without government's help.